Cash flow formulas, including free cash flow, discounted cash flow, operating cash flow, and statement of cash flows, are used to calculate business liquidity. Free cash flow is the amount of cash available for distribution, discounted cash flow calculates future cash flows, operating cash flow deducts certain expenses, and the statement of cash flows includes all cash inflows and outflows.
In business, cash is king. Many companies use a specific cash flow formula to calculate cash flow to ensure that they have sufficient business liquidity. Common types of cash flow formulas include free cash flow, discounted cash flow, operating cash flow, and statement of cash flows. The first three are simplistic formulas that require some estimate of future cash flows and what those numbers mean for a company’s current operations. The statement of cash flows is a professional statement disclosed to all company stakeholders as an official cash position.
Free cash flow is the amount of cash a company has to distribute among individuals or groups invested in the company. The basic formula for this calculation is net income, plus depreciation and amortization expenses, minus working capital changes and capital expenditures. Depreciation and amortization are added back to net income because these numbers are non-cash items. Expenses listed on the income statement for depreciation and amortization are simply accounting numbers. Changes in working capital are the additions or subtractions related to current assets and liabilities.
Discounted cash flow is a cash flow formula that takes estimated future cash flows and discounts them back to the current hourly dollar amount. This helps companies determine if new business opportunities are worth the initial expense. For example, a company that expects to earn $150,000 US dollars (USD) will discount that amount to the current dollar amount using the company’s cost of capital value. The interest rate cost of capital is what companies must pay for using external funds, whether debt or equity. This cash flow formula is primarily for use as a corporate finance forecasting tool.
Operating cash flow is a section of the statement of cash flows. This portion refers to cash inflows and outflows directly related to the company’s normal business operations. While similar to the free cash flow formula, operating cash flow has a few extra pieces. The formula deducts increases in account receivables, investment income, and other income from the firm’s net income. The company will add expenses reported as losses and deduct an increase in accounts payable, depreciation, impairment or other carrying amounts and financing expenses. The result is actual cash flow from normal business operations.
The statement of cash flows includes the operating cash flow formula and includes cash inflows and outflows from investing and financing operations. This allows the company to determine the cash flow from the sale of assets and generated from the sale of bonds, issuance of shares, payment of dividends and other activities involving the company’s cash resources.
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